Two years ago two well-known American
economists, Maurice Obstfeld und Kenneth Rogoff published a
noteworthy article . The pair introduced a theory that explains how the current
global imbalances could regain equilibrium. Triggered by a decline in the housing
market, the process would begin with a supply and demand shock in the United
States. As a consequence, domestic consumption would decline and the ensuing
recession would lead to a deterioration of the U.S. currency. It seems now that
the two had written a script for the U.S. and world economy for the years 2006
and 2007.

So where do we stand with the Obstfeld-Rogoff scenario? The
Federal Funds Rate has climbed from 1 of 5.25 percent within just a few years.
Mortgage rates have risen and are now around 6 percent. During the same time
period, an excess supply of housing units has flooded the market, particularly
in the major metropolitan and costal regions. There is no end in sight to the
drop-off in prices.

The U.S.A., domestic consumption depends to a large extent on
developments in the real estate market. The U.S. has a flexible system of mortgages
and real-estate financing. Equity extraction has fueled consumer spending. The Wal-Mart
chain, a barometer of U.S. consumption, had had a nominal to negative sales
trend which in real terms means a considerable decline.

Now the Dollar is weakening. We stand perhaps at the beginning of
part three of the Obstfeld-Rogoff-Horror-Story. They calculated that the potential
for a dollar-devaluation is between 20 to 49 percent. Two years an ago the dollar
dropped briefly to $1.36 per Euro. At that time the U.S.A. was not threatened
by recession, interest rates were low and the market anticipated continuing interest
rate increases. I venture no prognosis, but I wouldn’t be surprised to see an
exchange rate of $1.50-$1.60.

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It's interesting that the model the two economists used to describe
the mechanisms that will lead to a decline in the dollar. The did not make the
classic argument, according to which a devaluation causes a reduction of the current
accounts deficit, but rather, they argued the reverse: The purge in housing
prices was the trigger, followed by a consumer spending breakdown, followed by
a smaller demand for imported goods. The devaluation of the dollar is a quasi-byproduct,
and is exactly what we are experiencing at the moment.

Obstfeld and Rogoff wrote that from the European point of view,
the issue is clear. The European would have to reorient themselves just like
the Americans, only in the opposite direction, away from tradable goods and
into non-tradable goods. For Germany that would mean, we produce fewer pistons
and screws destined for export, but take taxi cabs somewhat more frequently, go
to the hairdresser more often and use other services.

Even in a supposedly flexible economic system like the U.S., it
will take some time for the domestic exporters to manufacture products that foreign
markets want to buy. This adjustment process all by itself would in all
likelihood cause a major recession. But this time, the recession will not pass
as quickly as it did in 2001, when the U.S. Federal Reserve Board [FED] reacted with a massive
lowering of interest rates and an enormous increase in the federal budget
deficit. Now, we there is much les freedom of action for the Fed. In the spring
the FED will probably lower interest rates by a quarter-point, and after that a bit further. But drastic reductions are not to be expected.

Obstfeld-Rogoff explain how things will
go in Europe. It is a script for the end of our small upswing bubble. Only with
great difficulty will our export-dependent economy manage to overcome a strong dollar-devaluation.
Our economy appears too inflexible to switch over to non-tradable goods. A hairdresser will increased prices as demand for his services increases,
and hire more hairdressers – which will not be easy to find on the German
labor market. This shows the need for greater structural reform: flexibility is
imperative to react more quickly to economic shock.

The dollar and the euro: Will the euro become the new currency of last resort?

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What happens next if the dollar slams into the ground? The first
breath of a European response came this week from the French Treasury Minister
Thierry Breton, who warned that the situation demands extreme vigilance.
European politicians will sooner or later demand some action be taken. Perhaps
there will be a few tactical interventions on the foreign currency markets with
the goal of outflanking one or the other speculator. But the reason for the devaluation
of the dollar is not speculation, but rather long-standing global imbalances
that in part, are now making themselves felt. Good old Breton may
stand quietly on watch, but there is no way to influence or predict exchange
rates. The only prognoses I dare to venture is the Obstfeld und Rogoff narrative
is on the right track.

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[Editor's Note: The author refers to the Bretton Woods system, which was the global system of monetary management for commercial and financial relations among the world's major industrial states after World War II ].